Market Minute: Putting The Correction Into Perspective

We officially had a market correction, which is defined as a 10% decline from a market’s peak, but a period of market consolidation was inevitable after the straight-up rally from the March 2009 nadir.

As the market climbed higher, shares moved from being slightly cheap (using a cyclically-adjusted P/E ratio) to expensive. Meanwhile spreads on high-yield bonds (the extra yield investors demand to hold company debt rather than government securities) fell from more than 16 percentage points at the start of 2009 to less than six points.

So we were due for a correction, but that is no reason for investors to fall into the fetal position. Corrections are pretty normal. According to David Rosenberg of Gluskin Sheff, corrections historically have occurred about every 12 months and tend to occur more in the second year of a rebound than in year one.

Market contractions like the last 30 days feel severe, but it must be viewed in the context of an 80% surge from the March lows. It would have been surprising if the markets had not paused to catch its breath. I laid out a plethora of market risks in my April 22 blog post and made it abundantly clear that this recovery will be bumpy and market pullbacks should not come as a surprise.

Before markets turn bullish again, we need to see LIBOR (London Interbank Offered Rate) spreads begin to narrow. LIBOR is the interest rate one bank charges another for a loan and serves as the benchmark for $360 trillion of financial products worldwide, ranging from mortgages to small business loans to credit cards. This key benchmark of interbank lending continues to rise, suggesting that there is rising caution even among banks about lending to each other. Banks’ reluctance to lend to each other stems from concerns about (1) the deteriorating quality of each other’s collateral as a result of the Eurozone’s financial problems, and (2) the U.S. financial reform bill that could adversely affect the credit ratings and profitability of major U.S. banks.

Of course, LIBOR is nowhere near the levels reached at the worst of the financial crisis back in October of 2008 – 3-month LIBOR is currently 0.537% compared to 4.81% in October 2008. Still, I’d expect investors want to see LIBOR come down before they start plowing money back into riskier assets.

Peter Lazaroff, Investment Analyst
http://www.acrinv.com/